This has been a year many investors would like to forget, with the S&P 500 index off to its worst first-half start in 50 years. Cryptocurrency markets have taken an even bigger hit, and Bitcoin is down over 50% since the beginning of the year.
The volatility in crypto markets has hurt many stocks, including the crypto bank Silvergate Capital (SI -3.85%). However, the bank surprised some investors when it announced stellar earnings results this week. Despite volatility in crypto markets, the bank crushed estimates, thanks to rising interest rates. Here's how.
Interest rates are increasing at the fastest pace in years
In June, the consumer price index (CPI), which measures the changes in the cost of consumer goods, increased 9.1% on an annual basis. This is the highest reading we've seen since November 1981.
In response, the Federal Reserve is raising rates to slow the economy and damp consumer spending. It hopes this brings down inflation. Since March, the Fed has raised interest rates from near-zero to a target range between 1.5% and 1.75%.
Rising interest rates have a ripple effect across the economy. Banking is among the industries that benefit when rates increase.
Specifically, banks collect interest on loans and pay interest on deposits, and the difference between these two is called net interest income. This tends to rise when interest rates go up because banks can take in more interest income than they pay out on deposits. This is where Silvergate has a major advantage.
Silvergate's deposit advantage over its peers
Silvergate provides banking services with a focus on cryptocurrency customers. One of its major products is the Silvergate Exchange Network (SEN), which enables cryptocurrency exchanges to transfer U.S. dollars between one another. The SEN has helped Silvergate increase its non-interest-bearing deposits significantly, giving it an advantage over traditional banks. Over 99.5% of Silvergate's $13.5 billion in deposits are non-interest-bearing.
The bank invests this money in a conservative portfolio of cash and other short-term securities with attractive risk-adjusted returns. The advantage to Silvergate is that as interest rates rise, its interest income from loans rises, while the interest paid out on deposits remains minimal.
Eye-popping growth in net interest income
Silvergate Capital brought in over $38 million in net income in the second quarter, representing growth of 41% from the first quarter and 84% from the same quarter last year. This increase was primarily due to net interest income, which was $70 million in the quarter, up 33% from the first quarter and 132% from the same quarter last year.
Silvergate benefited from rising interest rates, which increased yields across its interest-earning assets. The bank aims to keep high-quality loans on its books, and 97% of its securities are rated AA- or better. Furthermore, 55% of its securities have floating-rate interest rates, so when interest rates rise, its interest income will increase simultaneously.
What to expect
Silvergate Capital is a well-run bank that entered the cryptocurrency game early, giving it a big first-mover advantage. The move into crypto has given the bank a considerable leg up over its peers in the form of non-interest-earning deposits, which became apparent this year as the Fed aggressively raised interest rates.
According to the company, a 25 basis-point increase in interest rates would increase net interest income by $16 million over one year. Experts expect the Fed to raise interest rates another 75 basis points at its July meeting at the end of this month, which would translate into another $48 million in interest income for Silvergate in the next year.
Silvergate could also benefit if the Fed were to pivot and go back to cutting interest rates. That's because cryptocurrency prices -- which correlate with tech stocks -- might rise as could crypto trading volume, benefiting Silvergate's network products and putting it in an excellent position to profit, regardless of what the Fed does.